Tuesday, March 11, 2008

As the mother of all meltdowns looms, Fed bails out banks, while homeowners cash out 401k accounts

Nothing better illustrates the brutal economic asymmetry of the Bush years than today's headlines. "Stocks Shoot Higher on Fed Credit Plan" is how AP described the biggest market rally in more than five years. In what may yet prove to be another case of irrational exuberance, bank stocks surged and investors were bullish about the Fed's plan to pump $200 billion into the financial markets. (Or were they just giddy with schadenfreude about the downfall of Wall Street nemesis Eliot Spitzer?)

Meanwhile, the USA TODAY headline "401(k)s tapped to save homes" told a more depressing tale of how a growing number of financially strapped homeowners were cashing out their 401(k)s to stave off foreclosure, incurring hefty tax and penalty burdens, while depleting their retirement savings. The paper writes about Tamara Campbell, who lives near Denver and dipped into their 401(k) after her husband was laid off from his job last year and they fell behind on their mortgage. Campbell said they raided the 401k to stave off foreclosure. Now they're considering raiding the kitty again.
As Campbell considers whether to make another withdrawal, she notes, "It's not the kind of thing you want to use your 401(k) for. And if I keep doing this, I'm not going to have any retirement savings."
There's the asymmetry: Homeowners who can't make their payments either walk away from their homes or throw good money after bad in an attempt to hold on, mortgaging their futures to save their mortgages. In contrast, banks that can't raise capital can now borrow $200 billion from the Fed, unloading their bad debt on the Fed as collateral.

Paul Krugman wrote about the plan yesterday. While noting the bailout aspect, he was even more concerned that the $200-billion measure was a drop in the bucket compared to the true magnitude of the approaching meltdown.
The Fed’s latest plan to break this vicious circle is — as the financial Web site interfluidity.com cruelly but accurately describes it — to turn itself into Wall Street’s pawnbroker. Banks that might have raised cash by selling assets will be encouraged, instead, to borrow money from the Fed, using the assets as collateral. In a worst-case scenario, the Federal Reserve would find itself owning around $200 billion worth of mortgage-backed securities.

Some observers worry that the Fed is taking over the banks’ financial risk. But what worries me more is that the move seems trivial compared with the size of the problem: $200 billion may sound like a lot of money, but when you compare it with the size of the markets that are melting down — there are $11 trillion in U.S. mortgages outstanding — it’s a drop in the bucket.

The only way the Fed’s action could work is through the slap-in-the-face effect: by creating a pause in the selling frenzy, the Fed could give hysterical markets a chance to regain their sense of perspective.
Though Krugman dutifully noted the "face slap" has sometimes worked in the past, he didn't seem very optimistic.

Meanwhile, embattled homeowners at the other end of the economic spectrum have been getting slapped around a lot, and the situation just keeps getting worse. An America that has become radically divided along economic lines is experiencing our long, gradual financial meltdown in radically different ways.

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